We’ve always cared primarily about our social mission. This is a different approach for a public company to take.
Simply put: we don’t build services to make money; we make money to build better services. These days I think more and more people want to use services from companies that believe in something beyond simply maximizing profits.
– Mark Zuckerberg, Facebook CEO
(pages 67-70 of IPO registration statement)
Back in October 2010 I reviewed The Social Network movie, the semi-fictionalized account of how Harvard student Mark Zuckerberg founded social-networking website Facebook. At the time, I speculated that Facebook wouldn’t go public until “either 2012 or 2013.” With the February 1st filing at the SEC of an S-1 registration statement, it turns out that the Facebook IPO will occur sooner rather than later. IPO registration statements typically are filed a few months prior to a company going public, so I now expect the Facebook IPO to happen during the first half of 2012 (ticker symbol: FB). One thing is certain: it’s going to be huge with a first-day pop that will blow your socks off. What is less certain is whether the stock will be a good investment for the average person who buys in after the first-day pop.
Over the past year, I have analyzed the registration statements of two other social-networking stocks concurrent with or prior to their IPOs: LinkedIn (NasdaqGS: LNKD) and Groupon (NasdaqGS: GRPN). Neither company’s financials impressed me. Groupon was losing money – making a PE ratio meaningless — and LinkedIn was earning only $0.17 per share, which valued the stock at an astronomical PE ratio of 594. Anyone who bought either stock at the close of the first day of trading has lost money, down -15.2% with LinkedIn and down 7.9% with Groupon. In both cases, you were much better off waiting a full month after the IPO to buy.
Facebook Registration Statement Looks Good: Profitable
Below are some pertinent “pro forma” fiscal 2011 facts from the registration statement and the private stock auction site SharesPost:
- 845 million monthly active users (MAUs)
- Year-over-year growth in MAUs: 39% (p. 1)
- Revenue: $3.7 billion (p. F-12)
- Revenue from advertising: $3.2 billion (85% of total) (p. F-12)
- Year-over-year revenue growth: 88%
- Net income: $1.0 billion (p. F-16)
- Year-over-year net income growth: 65% (p. 9)
- Free cash flow: $470 million (p. 41)
- Year-over-year free cash flow growth: 150%
- Cash and equivalents balance: $3.9 billion (p. 41)
- Diluted earnings per share: $0.43 (p. 9)
- Shares outstanding: 2.33 billion (p. F-16)
- Valuation: $96.5 billion (Sharespost)
- Price per share: $41 (Sharespost)
- Amount raised in IPO: $5 billion (first page of filing)
Facebook Valuation is Expensive But Better Than Many Other Internet IPOs
Based on this data, we can compute some Facebook valuation ratios:
Price to earnings: 95.3
Price to sales: 26
Now let’s compare these numbers to those of other Internet companies at their IPO:
Price to Earnings
Price to Sales
Google (NasdaqGS: GOOG)
(Infinite because of negative earnings)
Yahoo! (NasdaqGS: YHOO)
(Infinite because of negative earnings)
The basic conclusion I get from this comparison is that Facebook is unusual among Internet stocks in its profitability. That’s a good thing. While its price-to-sales ratio is higher than most, its greater profitability may warrant it. After all, what counts is cash flow and earnings, not sales. Sales are simply a means to the end goal of profits. You can’t eat sales. Just ask any of the “dot bomb” stocks of the 1999-2000 Internet bubble. Google was the rare exception in that it was both profitable and priced at a reasonable multiple of sales. In contrast, the relatively low price-to-sales ratios of Groupon and LinkedIn make sense because they aren’t very profitable and consequently investors are not willing to pay much for profitless sales figures.
Facebook is Playing the Scarcity Game with Very Low Public Float
Based on a valuation of $96.5 billion, selling $5 billion in the IPO constitutes an initial float of only 5.2%, which would constitute an even lower float percentage than Groupon’s 6.3%, which at the time of its November IPO constituted the lowest percentage of shares offered by any U.S. Internet company in the past decade. This low float will guarantee Facebook a huge first-day pop, but is a red flag for me because it smacks of scarcity-induced stock manipulation.
Bottom line: Facebook is a real company that can turn a profit, so it will be a much better investment than most Internet IPOs, including LinkedIn, Groupon, and Zynga (NasdaqGS: ZNGA). I seriously doubt that Facebook’s stock will perform anywhere near as well as Google’s stock has since its August 2004 IPO. Facebook is an “upper middle class” Internet IPO, but short of royalty.
Facebook’s Business Model is Dangerously Skewed Toward Advertising
Keep in mind that Facebook’s growth – while historically impressive – is slowing and it recently missed its own internal revenue growth projections by a whopping $500 million. Although 845 million users create quite a “network effect,” Yahoo! arguably has a similar network effect with its web portal and yet it has struggled to convince its user base to buy anything. Like Facebook, Yahoo! gets almost all of its revenue from advertisers with only a sliver coming from users. Facebook users are willing to do that weird “poke” thing, as well as press “like” and play free Zynga games until the cows come home, but I’ve never bought anything on Facebook and I don’t think I’m unusual in that regard.
Furthermore, most postings on Facebook and other social media are really annoying and make me less likely to spend time on the site, let alone buy anything. I don’t really care if you’re tired or that you ate pasta for dinner. Most people agree with me that these kind of posts are “TMI” (too much information). Take, for example, tweets on Twitter. According to a recent academic study, people find almost two-thirds of tweets to be worthless. If Facebook users are similar to Twitter users and consider two thirds of Facebook posts to be worthless, Facebook’s future growth potential could be limited.
If you divide Facebook’s 2011 revenue of $3.7 billion by 845 million users, you get $4.39 — the amount of annual revenue per registered user. Compared to its competitors, $4.39 is very low. For example, Google gets more than $30 in annual revenue per user and even second-stringers like AOL (NYSE: AOL) and Yahoo! get $10 and $7, respectively.
On the positive side, the University of Chicago has found that social networking is more addictive than alcohol or nicotine and the Pew Research Center discovered that “the longer someone has been on Facebook, the more active they are.” In other words, most of Facebook’s existing 845 million users will stick around a long time and give Facebook a chance to figure out how to sell to them.
Facebook Needs to Diversify Revenue Streams or it Will Become the Next Yahoo! (Not Good)
The good news is that Facebook has captured 96 of the top 100 U.S. advertisers. The bad news is that these advertisers might not stick around since they reportedly are disappointed in the effectiveness of Facebook ads. According to Forrester analyst Nate Elliott:
We’re hearing from our clients that their return on investment from Facebook ads doesn’t look anything nearly like what it does for TV, print and radio ads, or from Google advertising. I don’t think this will be a problem in 2012. But if marketers find in 2012 that Facebook ads still aren’t delivering, I would worry about how much they spend in 2013.
Facebook’s revenue model is exceedingly simplistic. They sell lightly targeted static advertising badges. This is an ad model that hasn’t really changed since 1997.
Facebook is the new Yahoo. And they desperately don’t want to be Yahoo!
Granted, Google gets 96% of its revenue from advertisers (even more than Facebook’s 85%), but Google’s advertising revenue comes from paid search, which is a unique animal that has already proven its worth to advertisers — unlike the static banner ads on Facebook and Yahoo! Whereas Facebook desperately doesn’t want to be Yahoo!, it would love to be Google.
Facebook’s Future Profitability Depends on Conquering Social Search
If Facebook doesn’t want to meet the same fate as Yahoo!, it is going to have to go beyond display ads and monetize “social search,” which prioritizes search results by social interaction rather than relevance. As one analyst describes it:
If I want to purchase a new television, I could use Google, Yahoo! or Bing to gain access to several product listings and online retailers. I can learn a lot of information from running this kind of search, but the results still fail to contain a vital element to any potential customer experience: trust.
By contrast, suppose I ask my friends and family which television I should purchase. The responses I receive from my friends and family are probably not as comprehensive as my digital search. Nevertheless, because I trust my friend, the information I collect from them carries a different weight than the results I gain from an internet search engine.
Google is the king of search and Facebook is the king of social networking. Both companies are vying to be the first to combine the two skill sets and dominate the next phase of the Internet some are calling “Web 3.0.”
Wait at Least a Month Post-IPO Before Buying Facebook
Given the massive uncertainty that Facebook will come out on top in the Web 3.0 arms race, I think it best for investors to avoid Facebook stock until its sky-high valuation comes down a bit. At the very least, I would wait at least a month after the IPO to consider buying since almost all Internet IPOs fall back to earth after the initial first-day pop. Granted, Google bottomed only two weeks after its IPO, but Facebook is no Google.
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